Agency Basics - Setting Hourly Rates

In the past, traditional agency management felt that their compensation for their company would be higher if they convinced their clients to hire them on a fee basis.

Recently their has been a trend towards alternative agency/client compensation. However, in most cases, agency’s will still use a fee system that is comprised of an estimated cost that calculates X amount of hours at an hourly rate of Y.  Although an agency fee might be comprised of multiple hourly rates for individual staff members, one way to reduce, or discount the hourly rate, is to take the average hourly cost for the staff (or what is often referred to as a “blended” rate) and apply that cost to all of the estimated time. Although the blended rate is often used, the agency will still set out to determine the individual rates for each staff member.

Agencies will often not have the same internal calculated rates, since each business will have it’s own unique overhead and salary costs that would apply to only that company. However, agencies centered in certain geographical locations may have rates that are comparable. 

This standard for configuring agency/client fee agreements is often based on the number of FTE’s assigned to the client’s account.  One FTE stands for “fulltime employee equivalent.”

Billable Hours
Before we can review the formulas, we first need to determine the number of billable hours for your staff. We start with the number of billable hours in a year. In a normal work week you have 40 hours. (However, if you discount one hour for lunch you have 35 hours.) When you multiple the 40 hours by 52 weeks a year you get 2080 hours per year. Now we adjust the total hours to arrive at the billable hours. This compensates for the fact that some of the time we are sick or on vacation or taking the day off for July 4th or Christmas. Naturally, we would still like to be paid for those days, even though we can't bill for them. So we have to look at just the number of billable hours we really have. Traditionally, ad agencies have reduced 2080 to 1600 and use a number between 1600 and 1400 that will be used as the standard number of billable hours. Remember, the larger the number of base hours, the longer it takes fullfill those hours. A higher hourly rate and a low count can equal a lower hourly rate with a higher count.

When calculating the total number of billable hours, you may want to consider what percentage of a particular person’s time is billable. Although a creative or production person may be 100% billable, an account executive working on new business or administration person may not be. Industry average of billable time seems to be around 60% to 80% billable. However, I recommend that you set a goal of 1600, which is close to the 80% billable figure of 1664 hours.

Calculating Overhead
Next, we must look at the real cost that each person represent to the business. That is, not just the person’s salary, but any associated overhead that the business incurs. This would include some personnel related expenses such as employer share of payroll expenses or self-employment tax, health insurance, disability, life insurance, and other "non billable" expenses that are vital to the business. Other things in this category may include the prorated cost of computers, and other office equipment and furnishings as well as a prorated cost of the office space. In calculating the hourly rate for the person you need to add up their "contribution" to overhead to set their rates. As many accountants will tell you, a rule of thumb was devised whereby you figure the employee's overhead at 100% of the salary amount.

Formula 1-
Quick Overhead Calculation
A quick way of determining hourly rates for staff members is by using the formula below. This formula over-simplifies the calculation of overhead, by simply stating that the part of the agency’s overhead assigned to the individual is equal to that person’s salary plus 20%. (Only use this percentage if it covers your costs for the person’s benefits, insurance and annual bonuses.)
In order to figure out the hourly rate, you first need to determine the number of billable hours for that person. Next take the annual salary and add 20% (for the cost of benefits), and double the costs for your overhead. Take that number and add 0-40% for your agency profit. Divide the total number by the number of billable hours and you will get to your hourly rate.

Example A:
Person’s salary is $50,000,
multiply & add 20% = $60,000,
multiply by 2 = $120,000,
multiply & add 20% (profit factor) = $144,000
divided by 1600 hours =
$90 an hour.

Example B:
Person’s salary is $75,000,
multiply & add 20% = $90,000,
multiply by 2 = $180,000,
multiply & add 40% (profit factor) = $252,000
divided by 1600 hours =
$157.5 an hour.

Formula 2-
Hourly Rate By Factor
And even quicker formula is to take a person’s salary multiply it by a factor. (Formula 2 just simplifies the math of formula 1.) By multiplying a person’s salary by 2.5 you will get close to the cost of the person’s salary, benefits and overhead. Multiply it by a higher number to add in your profit. For example if you take the person’s salary and multiply it by 3 you get the total costs plus a 20% profit ratio. Or multiply by 3.5 to get to a 40% profit ratio. Once you decide on your factor multiply that number to the salary and divide the entire number by the number of billable hours to get the hourly rate.

Example A:
Person’s salary is $50,000,
multiplied by 3 = $150,000,
divided by 1600 hours =
$93.75 an hour.

Example B:
Person’s salary is $75,000,
multiplied by 3.5 = $262,500,
divided by 1600 hours =
$164 an hour.

Formula 3-
Let your accountant do the math.
The quick and easy formulas have been used in agency’s for a long time, however nothing beats having your accountant doing the homework and actually calculating your overhead so you can properly apply it in figuring your hourly rates. This is important, since all agencies will have varying overhead costs dependent on their rent, leases, electric, administration costs and so on. Feel comfortable at night by having this done. It will give you the most accurate basis for determining which final formula you use.

Finally - Calculate your Agency Blended Rate and apply it to the FTE calculations.